Report by Nitmal Bang:

Gold is generally known as the currency of last resort. Historically, this asset class has been favoured by investors during crisis and recessions when the dollar tends to lose its charm among investors. It also performed well during the inflationary phases as it is best suited as a hedge against inflation. Currently the world is coming out of the economic meltdown, the pain of which was felt in the last two years. The changing dynamics of the economies especially that of the U.S. made gold a preferred currency, replacing its tag as the currency of the last resort. We explore a number of factors that make us believe that gold may retain its sheen in the near future.

Investment demand in full force

Investment demand climbed to new highs in 2008 and 2009, led by western countries as they faced the most severe economic crisis in the history. Exchange Traded Funds (ETFs) hoarded gold like they never did before on expectations of an upside in bullion prices. The investment demand rose by as much as 300 percent in Q2 2009. In fact, it is investment demand that has been lending support to gold prices. Evidence of strong investment demand by ETFs coupled with hints of Chinese buying would lend further support to bullions.

Looking at the past

Tracing the past, it is validated that Gold has generally performed well during recession or slowdown and just before the economy starts kicking again and fears of inflation creep in. The weakness in dollar during such events acts as a driving force for gold prices. This phenomenon has been witnessed time and again. The dotcom bust in 2000-01 led to a massive slowdown in the U.S. economy, making dollar the last choice and gold the first choice for investors. The end of this phase gave birth to an aberration when gold and dollar surged simultaneously in 2005, breaking the negative correlation these asset classes hold. This development was attributed to two factors - rising inflation in the U.S. measured by Consumer price index which retained gold status quo and successive hike in interest rates by the Fed, which provided strength to the dollar. Sub-prime crisis was another event that testified the significance of the yellow metal in times of uncertainty. We believe the next phase would be marked by an inflationary phase accompanied by a subdued dollar, marking a new high for gold prices.

Gold has generally performed well during recession and when the economy starts inflating

Shape of the dollar in the coming quarters

In order to bail out the U.S. economy from the sub-prime crisis, the U.S. government announced an array of stimulus packages to the tune of $ 3 trillion. The Fed too joined the government and did its bit through monetary policies. It cut the interbank lending rates in the range of 0-0.25 % and initiated a $300 billion treasury buyback program to monetize debt. If estimates are to be believed, the huge money supply has given rise to a fiscal deficit of $ 1.75 trillion, which is 12.3 percent of GDP. It is now to be seen how long and how much can the U.S. government mop up its deficit from borrowing before resorting to currency printing spree.

Assuming that the U.S. government puts a stop to its quantitative easing program following the early housing sector recovery and the Fed on its part, does not extend its treasury buyback program, thus drying up liquidity in the market, the already ballooned fiscal deficit would still keep the dollar under pressure in times to come. China is adding to the worries of the dollar’s future as it seems to be reducing its exposure in the dollar and diversifying into other asset classes. These factors, along with the expectation of no hike in inter-bank lending rates in the next six months, would not allow the dollar to recover any lost ground.

Higher money supply pressurizing the U.S. dollar

Is China hoarding gold?

China was a laggard until 2008 as far as hoarding gold is concerned. This equation seems to be changing of late as it ramped up its gold holdings by 75 percent in 2009. After stockpiling huge volumes of industrial metals in the last 2-3 years, it may move on to precious metals as it diversifies its highly concentrated portfolio. Moreover, being the largest producer of gold and since most gold mining companies are owned by the Chinese government, China is believed to have vested interests in hoarding gold.

Going by the spread indicators, it seems that the U.S. sub-prime crisis has cooled off and the economy is all set to heat up from here.

U.S. financial sector getting back on track

Sovereign risk subsiding

Treasury Eurodollar spread indicates easing in liquidity and credit crunch

The Treasury Eurodollar spread (spread between 3M T-bill and 3M LIBOR), indicating the liquidity of U.S. dollars, retreated to earlier levels of 20-30 basis points recently after touching a high of 450 basis points in the second half of 2008, suggesting easing in liquidity crunch. The higher liquidity disbursement by banks and the unprecedented infusion of currency by the U.S. government will eventually pressurize the dollar and support gold prices.

Signs of expectations of a rise in inflation

The spread between the 10-year treasury notes and 10-year Treasury Inflation Protected Securities reflects the inflation expectations in the U.S. economy. It virtually entered the negative territory in the last quarter of 2008, sending deflationary signals before taking a turnaround only in the Q2 of 2009 with an improvement in economic data and rise in concerns of a build in inflation in the near future.

As expected, investors are resorting to bullion to shield themselves from the expected weakness in the dollar on early signs of inflation in the economy. Taking clues from early recovery in the housing sector and an overall improvement in the U.S. economy, it is possible that yields would go up even more as investors have already started shifting from treasuries to riskier asset classes.

In fact, the Federal Reserve’s treasury buying program kept treasury prices up, capping the upside in yields. Assuming that the Fed halts this program by the end of September, this step would also push the yields higher and generate renewed interest in gold.

Increase in speculative net positions on COMEX

Normally an asset surges when long positions build in it. A close look at the above graph indicates that from Sep ’07 gold prices rallied above $950 due to huge long positions build up by the speculators. The same can be seen in the later part of the graph as huge speculative positions have started building, carrying a potential of driving gold prices further up.

Gold sales by Central Banks under Central Bank Gold Agreement II shows a downward pattern

Under the Central Bank Gold Agreement II (CBGA II), which expires in September ’09, as many as 18 national Central Banks from Europe along with the European Central Bank had capped the sale of gold to 500 tonnes. The pace of sales under the current CBGA has slowed considerably over the years. As is evident from the graph, the remainder for the current year is still about 375 tonnes.

In fact, some non-CBGA banks have increased their holdings. China announced a 75% increase in gold reserves in the second quarter of 2009. The renewal of the Central Bank Gold Agreement for a third term reduced its ceiling on sales to 400 tonnes per year from its previous ceiling of 500 tonnes per year. These developments hint at hoarding of gold by banks as a diversification tool.

Gold mine output in a thin range

Irrespective of a significant rise in gold prices, the output has remained somehow in a tight range. As expected, if China gets in to the business of stockpiling gold seriously and ETFs continue to ramp their holdings, the limited mine supply would drive the prices higher.

Gold producers hedging activity on a decline

Hedging allows producers to lock in guaranteed prices for future output. But it can backfire if the price of spot metal rises above the hedged price. Buying back of outstanding hedge positions was a key element of demand in the past years. Hedging continues to go down and miners continue to de-hedge, indicating the bullish view of miners.

Gold and Crude oil

Historically, Crude oil and gold have shown almost a perfect correlation. Crude being the heart of economic engine, the demand for it is bound to improve in line with improvement in economies. Considering that an upside in crude triggers inflation concerns, it would provide support to bullion.

Cyclical pattern of jewellery demand

Demand for jewellery generally follows a cyclical pattern. It is at its peak during the 4th quarter in any calendar year. But this cyclical pattern took a beating in 2007 and 2008 as the US, the largest gold buyer was in doldrums. India, another major buyer, also witnessed a significant downside in demand as the sub-prime crisis trickled down to every corner of the world. In the current calendar year, Chinese jewellery demand showed a jump on the back of strong GDP. The demand in India, which has remained subdued so far, mainly on weak buying on low price expectations, is expected to look up on grounds of revival in the rains, the festive season ahead and as buyers get adjusted to prevailing high prices.

Indian scenario

Gold prices in India rose more in proportion to the rise in prices in dollar from 2008 onwards supported by the fall of rupee against the dollar as we witnessed tremendous outflow of funds from India. Going forward, we see a reversal in this trend on expectations that the funds coming back to emerging markets like India may strengthen the Indian rupee.

Outlook

Our outlook depends on dividing the world of bullions into two halves - investment demand and jewellery/physical demand. The indicators discussed above, affirm our conviction that investment demand would remain alive in Western countries backed by a weaker dollar and the onset of inflation in the US. China would play a very significant role in taking this metal higher from these levels. The kind of fall witnessed in the dollar recently must have given jitters to Chinese authorities. This development may compel China to intensify buying in gold to convert a significant part of their foreign exchange reserves in gold. In addition, a decline in sales by Central Banks and reduction in hedging positions by gold producers indicate that they too are expecting higher prices. An improvement in jewellery demand by non-western buyers like China, India and Middle East would be a bonus. We are of the firm view that gold will touch the levels of $1100 per ounce in the near term.